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The recent upheavals in markets have served to underline the potential in emerging markets (EM) once sentiment turns, writes our emerging market debt expert Jim Barrineau

15/02/2016

James Barrineau

Co-Head of Emerging Markets Debt Relative

One key tenet of behavioral finance is that markets tend to overreact. Thus, the current fear that major central banks are at the end of their ability to create inflation (at least in asset prices) seems premature.

Eventually that fear, should it continue, would invite a response meant to disprove the notion, and that would occur in a context of prices stretched far to the downside. We may not be there yet but eventually such a consideration should slow the current selling pressure.

A corollary to this is the realisation that growth is slowing in developed markets (DM). Such a world now looks a racing certainty, and part of the commodity correction is the story of producers adjusting to this new reality.

One of the most interesting facets of this tale is that emerging markets started pricing in a slower growth world as far back as mid-2013. We have witnessed a steady rise in EM fears as measured by aggregate credit default swap spreads and foreign exchange volatility over the past 30 months, during which period developed market bond and equity volatility barely moved.

It is only now that developed equity markets have started to respond. So if one concludes that markets have finally woken up to persistent growth disappointments, those parts of the asset spectrum that have already priced in that outcome should be most attractive to investors.

EM out-performing DM seems quite plausible – if not probable – according to this thesis.

Finally, if there is one single market to watch to gauge the prospects for EM it is the dollar. The below chart shows the stratospheric rise – and recent sharp correction – of the DXY spot dollar index since the spike in US Treasury yields at the time of the taper tantrum in the summer of 2013.

The careful preparations by the US Federal Reserve over these past 32 months before raising interest rates has arguably brought on this soaring dollar (and the recent market turmoil).

If now expectations of higher rates have to be unwound, that would be a significant bonus for emerging markets.

So far in February, despite the headlines about blood on the streets for US equities, the EM local currency bond index has outperformed its dollar counterpart by about 1% - and produced a near-2% positive return.

Asian and European currencies more than made up for Latin American softness. Coming after three consecutive years of losses and a return last year that beat the previous worst by an astonishing 600 basis points, it’s easy to see how powerful any reversal might be.

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